1. Introduction

China’s No.1 hotpot chain Haidilao Group finally filed for IPO on 17th May 2018 after almost 4 years of IPO rumours and sending its sole soup base condiment supplier Yihai International into its all-time high since listing. Considering its fairly predictable of cash flow and bright growth prospects, there is little wonder why it is trading at over 50x P/E in today’s volatile market environment.

Despite trading close to it’s all-time high level, there seems to be some room for its share price based on a DCF implied value of HKD 21.1, representing 22% upside. It is still relatively cheap on a forward P/E of 37x.

2. Simple business model

Yihai is Haidilao’s soup base condiment production arm which was spun-off and listed on the main board of HKex in July 2016.

The company’s products are mainly made from soya bean oil, animal oil, chilli, flower pepper, etc. According to its prospectus and annual report, soya bean oil was the primary cost driver of its cost of raw materials, which accounts for about ~20% of the cost.

It then sells the finish goods to either Haidilao Group (“Related Party”) to be consumed in its chained restaurant, or sold to 3rd party distributors such as supermarkets for retailing.

3. Shareholder & Management

Post spin-off, Yihai international is still ultimately controlled by the founders of Haidilao Group, which consist of Mr. Zhang Yong and Ms. Shu Ping, Mr. Shi Yonghong and Ms. Li Haiyan. This ensures shareholder interests between the two companies are well-aligned and Yihai is ultimately benefiting from the growth of Hadilao.

Its day to day business are directly managed by young and internally promoted professionals aligned with Haidilao’s culture and practice.

CEO, 45, Ms. Dang Chun Xiang, joined Sichuan Haidilao and served as the head of the operations department from January 2011 to December 2014. Her role expanded to deputy general manager from January 2014 to December 2015.

CFO, 38, Mr. Sun Shengfeng, joined Sichuan Haidilao in September 2007, and has held various positions successively: assistant to CFO, chief accountant, deputy head of the finance management department, deputy head of the asset management department.

4. Proven track record

Revenue: Almost doubled from 2015 to 2017, benefiting from the expansion of Haidilao group and growth of 3rd party sales

EBIT & EBITDA Margin: improved from 20% level to 25% from 2015 to 2017. In terms of % of sales, all expense items are fairly stable despite a fast-growing sales level, which means the expense structure is fairly mature and does not rely on heavy marketing or discount to sustain.

Expenses: as a manufacturing entity, the largest non-material cost is distribution expenses and it accounts for about 9% of the sales value.

5. The hotpot industry (How much it is expected to gain from Haidilao’s IPO)

For the past 5 years, about 55% of its revenue came from Haidilao hotpot. Judging by Haidilao’s queue at each outlet one will gain a rough idea of how sustainable its business model and growth prospects are. Its performance dictates Yihai’s performance to a large extent. Since more than 90% of Haidilao’s revenue comes from the PRC, it makes more sense to focus on the hotpot industry in China.

PRC hotpot industry grew at 11.6% CAGR from 2013 to 2017 according to Frost and Sullivan, outpacing the overall F&B sector. It will continue to outgrow the overall F&B sector with 10.2% CAGR.

According to Frost and Sullivan, the hotpot industry is the biggest segment among F&B industry and accounted for 13.7% of the overall market share. An F&B white paper published by the Chinese version of Groupon, Meituan, shown an even higher share of 22%.

Haidilao’s sales growth outperformed by market standard by more than 3 times and was recognized as one of the top 10 hotpot brands by the Chinese F&B association from 2013 to 2016. It also has the highest market share among other Chinese hotpot franchise, almost achieve a share that is more than 2x of the 2nd player Xiabuxiabu catering.

6. Sales to 3rd party sales (How Yihai has grown and will likely to grow outside of Haidilao Chain)

While Yihai’s total revenue was growing at 39.4% CAGR from 2015 to 2017, 3rd parties sales also grew at a similar CAGR at 38.2%, reflecting a strong demand for its condiment products beyond just Haidilao stores.

The growth was organic. Not only because it is able to maintain its sales growth to 3rd party distributors but also because it achieved this result with no debt and no additional equity injection.

7. Competitors

For valuation purpose, the normal method is to use the Sum of the Part (SOTP) method and compare a company’s business segment against relevant sector competitors. One would need to find a group of condiment companies that supply to hotpot restaurant and companies that supply hotpot condiment base for supermarkets.

However, there aren’t many listed food and beverage companies in China. And most sauce and condiment producers manufacture products such as black soya source, chilli sauces and oyster sauces, which makes it not very useful to consider them as comparable to Yihai.

Since technically, Yihai’s business is largely correlated to hotpot industry as the end customer to their products are either diners at Haidilao Chain restaurants or hotpot enthusiasts that buy hotpot base(s) and prepare meals at home.

Therefore, only hotpot companies will be taken into consideration, and some of them do sell hotpot soup base condiments.

As can be seen from the table above, apart from Haidilao which ranked 1st, Xiabu Xiabu is currently listed in Hong Kong and Xiao Wei Yang is a catalyst stock (non-accessible to retail clients) in mainland. While the other 2 are not listed entity, therefore, only Xiabu Xiabu and Xiaoweiyang are comparable.

7.1) Business Model

Yihai: Spun-off from Haidilao hotpot, mainly sells soup condiments.

Xiabu Xiabu: Fast food style one person small hotpot, which has condiment subsidiary.

Xiaoweiyang: Traditional hotpot, which has condiment subsidiary.

7.2) Revenue and Growth

Yihai’s revenue growth is faster than the other two players in from 2015-2017, and it is very sizable considered it was originally a business unit from the hotpot chain.

7.3) Profitability

Being a raw material supplier resulted in lower gross margin compared to the hotpot restaurant players but contributes higher EBIT and Net Margins. Yihai’s EBIT margin had grown from ~20% in 2015 to 25% in 2017, its net margin has also grown by 1.2ppt to 15.9%.

8. Risk

8.1) Feasibility of the Haidilao Expansion

Haidilao’s IPO will certainly help the group strengthen the position as market leader, although the amount raised is not disclosed but an earlier Reuters article indicated that Haidilao plans to raise US$700m. This amount could help the chain to open another ~300 stores (60% of the IPO amount will be used to fund expansion and each new store requires 8 – 10 million RMB capital outlay as disclosed in the prospectus). At the end of 2017, Haidilao had 273 stores, the company had disclosed a plan to open about 200 stores by the end of 2018, representing a 73% capacity increment. They had already opened 50 stores and signed a lease agreement with another 84 locations as of the latest practicable date.

8.2) Sustainability of the Haidilao business

To understand how sustainable and realistically its business model can last, Singapore can be used as a proxy for illustration. Most of people would agree that one of Haidilao’s main target customer in Singapore are PRC nationals residing in Singapore and this scope can be further expanded to cover the entire Chinese population. According to the Department of Statistics of Singapore, the city-state has 5.613 million population at the end of 2017, with 74.3% or 4.17 million of the population are ethnic Chinese.

With Haidilao’s 6 Singapore restaurants (2017) serving a target population of 4.17 million, each of them actually service a population of 0.695 million. Compared to one of the more comparable tier 1 cities in China, Beijing, where Haidilao served 21.71 million Beijing population with merely 28 restaurants. Each Beijing branch serves approximately 0.775 million people, the country’s capital had an even lower “restaurant to target customer ratio” as compared to Singapore. Not to mention many consumers in Singapore still have to endure a long waiting time to be served. If we further expand this comparison to other economically more advanced coastal provinces, we could see there is still a plenty of opportunities for Haidilao to grow in even in tier 1 and 2 cities in PRC.

8.3) Rising raw material cost

With the Chinese retaliated the Trump’s trade war and included soya bean as its major component of the response, should the price of soya bean rises, Yihai’s result will be adversely affected.

However, based the Dalian Commodity Exchange’s soya bean futures contract movement, the price did go up this year’s March when President Trump first announce his tariff plan and it stays at higher level till July. The overall soybean price level remained at a similar level compared to mid-2016, when Yihai was listed in HK exchange.

Hence, unless the price of soybean increased drastically again, this will have little impact on Yihai’s cost of raw materials.

9.Pro-foma Financial Statements

Haidilao contributes to more than half of the Yihai’s sales for the past 5 years, hence it is important to understand and forecast Haidilao’s sales via a bottom-up approach to infer the growth of Yihai.

9.1) Haidilao’s Revenue Assumptions

Table Turnover rate: Improving towards 6 times per day, based on store operating hours of 18 hours per day, and consistently improving turn over from 4.0 in 2015 to 5.0 to 2017.

Number of days opened for operation: For tier 1 and 2 cities, 5% decreased in the first 2 years and increase at 10% per towards 365 days per year. For tier 3 and overseas stores, assumed 10% constant increment towards 365 days per year. This is because despite a large number of stores opened throughout a year, and especially a large number of them opened in the tier 3 cities in 2017, the operating days improved in these stores. And it is natural for F&B business to operate throughout the year.

Average Restaurant Capacity: Assumed constant

Average spending per guest (RMB): Assumed grow with China’s inflation, 2.2% in 2018, 2.6% for 2019, and 3% beyond 2019. For overseas stores, assuming inflation of 2% based on an advanced economy as most of its overseas stores are located in developed countries.

# of Store opening (China): For tier 1 and 2 cities, assumed same growth increment based on history for the first year, and growth rate is reduced by 50% each year thereafter. For tier 3 cities, assumed average historical growth rate for the first year, growing at 50% of previous year’s growth rate throughout the rest of the forecasting period.

# of Store opening (Overseas): Assumed 1 store opened in each market except Taiwan where the potential market size is much bigger and already mature for hotpot concept. Assumed 0 stores opened for Singapore after the first year, 1 stores for the rest of the market except Taiwan.

Outcome: There will likely be 406 stores opened for the first 2 years, based on the analysis in the previous sections that Haidilao could open about 280 to 350 stores purely relying on its IPO proceeds.

Forecast formula:

Total guest served = Table turnover rate (times per day) * Number of days in operation * Seating Capacity in restaurant * Number of restaurant

Total revenue = total guest served * average guest spending

Or

Average guest served per day per restaurant = Total guest served / Number of days in operation / Number of restaurant

Average restaurant daily sales = Average guest spending * Average guest served per day per restaurant

Total revenue = Average restaurant daily sales * Number of days in operation*Number of restaurant

9.2) Yihai’s Revenue forecast

Sales to Haidilao: Expressed as a fixed percentage to Haidilao’s cost of goods

9.3) Yihai’s Financial Statements

Income Statement Assumptions:

Gross Profit: an average of historical and assumed constant thereafter

Non D&A Distribution: As % of sales, assumed same as latest historical number

D&A: based on capex schedule

Administrative expenses: As % of sales, assumed same as the latest historical number

Other incomes and gains- net: Removed one time items, assumed constant % of sales for government grants and consulting income

Fair value loss of redeemable convertible preferred shares: Assumed zero since there are no more convertibles

Forex gain/losses: Assumed zero

Interest Income: As % of Beginning cash balance, assumed same as the latest historical number

Income tax: Assumed Chinese statutory tax rate

Balance Sheet Assumptions:

Inventories: Assumed as % of cost of goods sold, constant throughout forecasted period

Trade & other receivables: Assumed as % of sales, constant throughout forecasted period

Trade & payables: Assumed as % of cost of goods sold, constant throughout forecasted period

Capex: Assumed existing capex and new capex depreciate over a fixed tenor based on information inside Annual Report. The useful life for land, PPE, intangibles (office software) are 50 years, 20 years and 5 years respectively. Assumed new capex based on the historical level.

Debt: Assumed no additional debt since the current interest-bearing debt is zero

10. Valuation

10.1) Discounted Cash Flow

Based on the Discounted Free Cash Flow method, HKD $21.1 per share was derived (as the amount was discounted back to Dec 2017, December 2017’s outstanding number of shares was used instead of the latest in 2018).

10.2) Relative Valuation

With its current price of 17.28 HKD per share, it is trading at 54.4x P/E using 2017’s earnings, and 30.5x using forward 2018E earnings.

11. Conclusion

While may rightly point out that a manufacturing company with F&B exposure is not worth 30x forward P/E, considering the close relationship between Yihao and Haidilao, the former provides a “cheaper” proxy to ride on the multi-year expansion phase of the latter.